Why it’s worth defending rational expectations theory

by on June 9, 2009 at 6:51 am in Economics | Permalink

RSuleiman, a commentator over at Ezra Klein, writes:

Having just finished reading the paper, it seems very much of a piece
with Professor Cowen's other post-crash writings, and yes, it does seem
to be designed as a defense of the rational markets hypothesis.

He is referring to my piece on the crash.  Suleiman's is a common response but it is neglecting why rational expectations (RE) models are so powerful and also, at least among economists, so popular.  Economists try to fit various phenomena into RE models to show that the mechanisms underlying those phenomena are general and not relying on some very specific set of assumptions about expectations.  The goal is not to convince everyone that expectations, or markets, are indeed rational.  They're not, at least not always. 

The goal of an RE model is to establish the universality (or lack thereof) of a specified problem. 

There are people who misuse rational expectations techniques, but don't let those mistakes mislead you.  Krugman and Stiglitz also have used RE a lot as a modeling device, although they are (properly) willing to abandon it as a descriptive assumption in many cases.  A market failure argument with RE is often more powerful than a market failure argument without RE.

1 Luis Enrique June 9, 2009 at 7:24 am

Do you have a response, that you are willing to publish, to Robert Waldmann’s comments on that paper?

2 Grant June 9, 2009 at 9:20 am

In what sort of circumstances is an assumption of rational expectations accurate? I was persuaded by this paper, because it more realistically assumes heterogeneous expectations.

3 Chai June 9, 2009 at 10:43 am

I’m not too familiar with it, since I am an undergraduate, but I don’t remember seeing ever that a) the Rational Expectations Hypothesis was time-dependent. I recall it being that every person is completely rational at every single point in time or b) that if people had rational expectations, the law of large numbers would follow.

Can someone explain those two proofs to me? Until then, I seem inclined to agree with Waldmann, even though he was rather rude.

4 Mitch June 9, 2009 at 11:35 am

Economists try to fit various phenomena into RE models to show that the mechanisms underlying those phenomena are general and not relying on some very specific set of assumptions about expectations.

I don’t understand how using an RE model makes your results more general. Isn’t an RE model precisely “a very specific set of assumptions about expectations”?

5 David C June 9, 2009 at 3:29 pm

“In what sort of circumstances is an assumption of rational expectations accurate? I was persuaded by this paper, because it more realistically assumes heterogeneous expectations.”

I don’t think Tyler Cowen is arguing that the theory of rational expectations is correct. Far from it. He’s talking about eliminating possible causes of a problem. If you have a model that includes rational expectations that identifies a problem in the market place, then you can safely eliminate that consumer assumptions are the cause of the problem, and you’re able to look for other causes. If you don’t have RE in a model, then your model has to guess what the consumer expects; this will increase the likelihood of an error.

“A market failure argument with RE is often more powerful than a market failure argument without RE.”

Taking this the other direction, a market success argument with RE is often less powerful than a market success argument without RE. I assume this statement is less often true than the one you made, but is it still correct?

6 Ricardo June 9, 2009 at 11:06 pm

The problem with Waldmann’s comments is that he evidently did not read the paper before embarking on his rant: he read only the one paragraph quoted by Ezra Klein.

Cowen’s paper really is about expectations and how they are formed, not the efficient markets hypothesis.

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